The return of interest-only mortgages

These loans promise low monthly payments, but plenty of risks

By

AnnaMariaAndriotis

Affluent borrowers are signing up for the same type of mortgage that pushed many homeowners into foreclosure just a few years ago.

Interest-only mortgages, in which borrowers pay interest but no principal during the first few years of the loan, are attracting buyers who like the lower monthly payments—and can divert the savings to income-generating investments.

Lennar

Lenders say these borrowers are attracted to the loans’ low monthly payments, which can be 30% to 40% lower than regular mortgages. And with interest rates near record lows over the past year, these loans have become even cheaper.

Interest-only mortgages accounted for about 14% of private mortgage originations from January 2012 through October, according to the latest data from CoreLogic, a real-estate analytics firm. (Private loans are mostly held on lenders’ books rather than sold to government-backed agencies.)

National lender EverBank
US:EVER
says interest-only loans make up 15% to 20% of all the private jumbo mortgages it originates. At Bank of New York Mellon’s
BK, +0.05%
wealth-management group, applications for interest-only private jumbos increased nearly 50% so far this year compared with the same period in 2012. “This has been a very robust first quarter for us,” says Erin Gorman, national mortgage sales director with the group.

Other lenders are entering the market. For instance, in April, lender and servicer Stonegate Mortgage Corp., based in Indianapolis, will roll out interest-only private jumbos. Jim Cutillo, chief executive of Stonegate, says he expects many wealthy borrowers who would have applied for adjustable-rate mortgages (ARMs) to instead turn to interest-only jumbo loans, specifically those that have fixed rates.

Likely to spur demand are new mortgage rules announced earlier this year by the Consumer Financial Protection Bureau. Starting in 2014, lenders offering ARMs will have to evaluate borrowers based on their ability to pay a higher interest rate than the initial rate on the loan. As a result, some applicants will find that they qualify for a smaller mortgage. Cutillo says Stonegate’s interest-only mortgages will have a fixed rate for the duration of the loan, allowing home buyers to maintain borrowing power.

Still, under the CFPB’s rules, lenders who continue to provide interest-only mortgages beginning next year could face greater liability in lawsuits filed by borrowers who fall into foreclosure. But lenders are playing down the risk, saying that they provide these loans only to affluent borrowers who have significant assets and are unlikely to fall behind on payments.

Most of these loans permit interest-only payments for the first 10 years, making them appealing to buyers who plan to sell their home within that period since they won’t have to pay principal toward the loan. On a 30-year $1 million mortgage with a 4.08% fixed rate—the average rate on private jumbos, according to mortgage info website HSH.commonthly interest-only payments come out to $3,400, compared with roughly $4,820 a month for interest and principal.

Separately, some affluent borrowers find these mortgages provide more flexibility. For instance, wealthy self-employed borrowers with seasonal fluctuations in their income, as well as individuals whose bonuses make up a large chunk of their income, often prefer interest-only mortgages because of their small monthly payments and the ability to make larger payments, if they prefer, when they have the extra funds, says Tom Wind, executive vice president of residential lending at EverBank.

The loans also have flexible payment options. Borrowers who want to prepay the principal can do so without incurring a penalty in most cases.

Still, these loans come with many risks. Borrowers won’t build equity in their homes with interest-only payments, and if home prices fall, they could end up owing more on the home than it’s worth. Here are a few other issues to consider.

More up front: Some lenders require larger down payments, which can be 30% or more, than they would with a regular mortgage.

Higher interest rates: Some lenders will charge higher rates, often ranging from 0.12 to 0.25 of a percentage point more, than they would with a mortgage that requires principal and interest to be paid monthly.

Liquidity needed: Most interest-only mortgages have adjustable rates, which means borrowers could see their monthly payments get bigger if rates begin to rise. Borrowers should consider whether they have enough liquid cash to manage sudden spikes in payments.

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